Lower oil prices are no reason to panic

There are numerous reasons why the oil price has been falling. China's growth is slowing, OPEC is happy to keep pumping the same amount of oil regardless of price, shale producers are adding to supply and fears are increasing that Europe is again heading for the economic abyss.

Companies big and small have been hit hard, and not just in the oil sector. Anything related to the resources industry has been sold off. If the oil price is going to stay low then the sell off might be justified, but is this merely a short term phenomenon or something more sinister?

A long game

Let’s inject some rationality into the mood. First: don’t panic. Share prices have responded rationally to oil prices and there is no rush to buy or to sell. There has been a lot of market action but that doesn’t mean investors need to respond with hyperactivity of their own. A long game is currently underway in oil markets.

Shale oil production from the US is challenging the status quo. Like iron ore, plenty of supply has been added. Unlike iron ore, almost all of it is high cost production that is now under stress.

The best solution to low prices is low prices and we expect that, within the next 12 months, supply will exit oil markets and stabilize prices. Deepwater conventional fields, Canadian tar sands and plenty of US shale output simply isn’t economic at current prices. Shale incurs total costs of between US$70-80 a barrel. We expect oil prices to eventually settle somewhere in this range but, with a lot of producers using hedging, that could take time.

It isn’t just oil prices influencing supply, zero interest rates play a role. The entire shale oil industry depends on the availability of cheap money. Very few (if any) shale producers generate free cash flow. All need vast reservoirs of cash to maintain, let alone grow, output. A change in credit conditions could dramatically alter the economics of shale oil. That’s not to say that the entire industry is a bubble, but it is more fragile than traditional output and its dominance has been overstated.

Of course, we could be wrong about shale oil. The economics are tough to peg down because they vary at each drilling location. We would reconsider our position if shale output does not decline in response to prices. That's why recent prices should not be treated as an invitation to go all in. Often it's better to let the dust settle, though we hope to add some high quality names to our Buy list soon.

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